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Charlie Munger's Love Affair With Costco

Anatomy of a highly loved company.

Berkshire Hathaway(NYSE: BRK-B) Vice Chairman Charlie Munger isn't one to mince words, but his recent plug for Costco(Nasdaq: COST) had an almost fanatical level of bluntness.

Asked about his favorite company outside of Berkshire, Munger literally interrupted the questioner and answered, "That's easy. It's Costco."

"It's one of the most admirable capitalistic institutions in the world. And its CEO, Jim Sinegal, is one of the most admirable retailers to ever live on this planet," he gushed. "I just can't say enough about my admiration for Costco. More of you should look at Costco. In fact, every time Donald Trump says something and you get discouraged, you should think about Costco."

He wasn't done. "It has a frantic desire to serve customers a little better every year. When other companies find ways to save money, they turn it into profit. Sinegal passes it on to customers. It's almost a religious duty. He's sacrificing short-term profits for long-term success."

This wasn't the first time Munger let his admiration run wild. Last year he said, "Generally speaking, I believe Costcodoes more for civilization than the Rockefeller Foundation."

What's behind these accolades?

Part of Munger's obsession with Costco is its corporate culture. "It's a total meritocracy," he said. Co-founder and CEO Jim Sinegal earns a few million a year -- a rounding error in the corporate executive world -- answers his own phone, spends 200 days a year visiting stores, and strikes you as a retired middle-class neighbor more than the head of one of the world's largest companies. Costco employees don't wear uniforms. Street clothes and a nametag get the job done -- an idea that saves money while humanizing workers. "Our intention is to try to build an organization that is going to be here long term," Sinegal told The Motley Fool two years ago."And we think you do that by paying attention to some very, very basic things."

Those things, in order, are: Obey the law, take care of your customers, take care of your people, and respect your suppliers.

Shareholders, you'll notice, aren't part of the list. But that hardly means they're forsaken. Costco might be one of the best examples of how happy customers and employees naturally lead to happy shareholders. Sinegal likes to note that Wall Street constantly jeers Costco for being more generous to employees than shareholders, yet its stock consistently trades at one of the highest multiples in the retail industry, well ahead of Home Depot(NYSE: HD) or Wal-Mart(NYSE: WMT). Since 1995, Costco has returned 1,000% to shareholders; the S&P 500, less than 200%. Whatever Costco's doing -- deliberately shareholder-centric or not -- works.

Those margins are so thin they're nearly irrelevant. For comparison, Wal-Mart's margins are almost 6%.

The winners, of course, are Costco's customers. Take a company that prices goods just barely high enough to cover overhead costs, add in the natural savings from selling in bulk, and the odds are overwhelming that Costco customers are getting the lowest prices possible. That, in essence, is the company's goal -- or religious duty, as Munger would say.

The lengths it goes to to uphold that goal are nearly boundless. In 2009, Costco wasn't happy with Coca-Cola's (NYSE: KO) prices. Rather than stick customers with higher costs, it simply stopped carrying Coke products altogether. "At this time, Coca-Cola has not provided Costco with competitive pricing so that we may pass along the value our members deserve," read signs over empty store shelves. Most retailers ask how high they can push prices without sacrificing sales. Costco asks how low it can push them while still covering operating expenses.

All the while, the company is still quite profitable. The secret is that essentially all its profits come from membership fees. Total net income in 2010 was $1.3 billion; membership fees that year were $1.7 billion. The year before, total net income came in at $1.1 billion; membership fees, $1.5 billion. That's Costco's deadly weapon: price goods cheaper than any competitor reasonably can, but still reap respectable profits off membership fees.

It's a win-win for members and shareholders. For an average member who spends $1,200 a year at Costco, membership fees -- as low as $50 a year -- aren't much, and well worth it financially. For shareholders, 63 million of those membership fees, with a renewal rate of 88%, equal big, stable profits. And there's a psychological benefit to the membership model: Paying a token fee once a year and enjoying cheap goods year-round feels better than buying average-priced goods all the time.

The question is whether Costco stock deserves your money. "The world has figured Costco out, which is why it trades at 25 times earnings," Munger said. "If you're comfortable with that, Costco is one of the most admirable capitalistic institutions in the world."

Valuation is what has always kept me away from the stock. At some point, however, you have to get comfortable with paying for quality. Costco is a terrific company. Is it worth the price? You tell me in the comments section below.